A "trust" is a legal arrangement where a separate legal entity is created (the "trust") and the person making the trust (the "settlor"), transfers ownership and legal title of certain property to the "trustee." The trustee, in turn, is responsible for using the property for the benefit of a third party (the "beneficiary"), who was specified by the settlor when he or she made the trust.
For a trust be valid, it must have a valid purpose and the purpose can't be illegal or against public policy. For example, a trust that is created to for the purpose of repaying illegal gambling debts is invalid.
Similarly, trusts that are designed to avoid federal income taxes are invalid. Such trusts are considered "shams" and the Internal Revenue Service ("IRS") will ignore such trusts and their transactions and the tax liabilities will be imposed on the true "owner" of the taxable income, which is usually the settlor and/or beneficiary.
If you're looking to create a trust, you need to be aware of several schemes that won't help you to lower your taxes or protect your property, but rather could expose you civil or criminal penalties at the hands of the IRS.
Trusts and Taxes
In general, trusts are designed so that property held by the trust generates income, and the income is given to the beneficiaries. The trust property, or "trust principal" or "trust res" remains in tact and continues to generate income.
All income a trust receives is taxable to the trust, to the beneficiary, or to the grantor of the trust. Generally, a trust is given a deduction from its taxable income for distributions that are made to the beneficiaries. Many sham trusts take advantage of this deduction by naming other trusts as beneficiaries: a sham trust makes a distribution to trust 1 and takes a deduction; trust 1 makes a distribution to trust 2 and then takes a deduction. This process is repeated until there is little or no income to report to the IRS.
As a general rule, a valid trust will not give you a tax deduction for your personal, living, or educational expenses, nor will it try to avoid or evade income taxes by hiding assets or property.
Trust Shams and the IRS
The IRS continually investigates and prosecutes trust sham activities. Recently, the IRS has identified numerous trust shams, which typically promise various types of tax benefits, such as
- Reducing taxable income, or eliminating it completely
- Deductions for personal expenses paid by the sham trust
- Reducing or eliminating self-employment taxes, and
- The reduction or elimination of gift and estate taxes
In addition, the IRS has identified two general schemes in which trust shams are presented, namely, "domestic trusts" and "foreign trusts," and each has several types of shams.
Domestic trusts are trusts created in the United States. Some common domestic trust shams include:
- The "business trust," which is also called an "unincorporated business organization," a "pure trust." or "constitutional trust," makes it appear that the taxpayer-settlor has given over control of his her business to the trust, but the taxpayer-settlor actually retains control of the day-to-business activities through a trustee. When such trusts are found, the IRS can tax the taxpayer-settlor, or treat the trust as a corporation and tax it as such
- The "family residence trust," in which the taxpayer, usually with his or her spouse, gives the family home and furnishings to a trust, which in turn takes deductions for expenses of maintaining and operating the home, as well as depreciation - the lessening of value caused by normal wear-and-tear. Usually, the IRS taxes income to the taxpayer-settlor and/or his or her spouse and disallows the expenses
- The "charitable trust," where the trust claims to be a charitable organization, and the taxpayer-settlor transfers property or money to it. The trust then pays for personal, education or recreation expenses on behalf of the taxpayer or his or her family, and then it claims deductions for such payments. Because the "charitable" organizations are not qualified as such, contributions to them are not deductible, and the contributions are included as taxable income to the taxpayer-settlor
Foreign trusts are trusts that are formed, or end-up in, a country other than the United States, and usually one where trusts are subject to little or no income tax. In these types of shams, taxable income is filtered through several trusts or organizations before it finally is paid to the taxpayer-settlor. The proponents of the sham promise that the final distribution can't be taxed by the IRS.
Foreign sham trusts involve a complicated series of trusts, offshore bank accounts and other foreign business entities. The main idea is to create a series of trusts in a foreign county where there are no IRS filing requirements and/or it is impossible for the IRS to determine who is in control of the trusts. The proponents of such shams are wrong on both accounts. In many instances, the IRS easily shows that the taxpayer-settlor is still in control of his or her business, like a failed domestic "business trust," and the trust income is taxable to the taxpayer-settlor.
Questions for Your Attorney
- Is it illegal for me to invest in a foreign trust?
- What kind of trusts do you recommend if I want to protect some of my assets if I'm ever sued?